Originally Published in FINANCIAL TIMES

How to save the rouble

Personal View

Martin Feldstein

Russia should use the international bond markets, not the IMF or
G7 to rebuild its foreign reserves and shore up its currency.

Russia desperately needs more foreign exchange reserves. Its
reserves have fallen by about a third from more than $2Ob a year
ago. The foreign-currency debt obligations coming due in the next
12 months are 50 per cent greater than available reserves, the
kind of imbalance that triggered last year's run on the South
Korean won. And the current account deficit is depleting reserves
at the rate of $1b every two months.

Russia's reserves are not enough to reassure foreign creditors
they will be paid if they choose not to roll over existing loans.
To prevent a run on the rouble, the Russians were temporarily
forced recently to raise the rouble interest rate to a staggering
150 per cent.

A collapse of the rouble would reverse the prodigious achievement
of reducing annual inflation to just 7 per cent now from 130 per
cent in 1995. A rise in inflation now would tell the Russian
people that the government had failed at the most visible aspect
of economic policy. A collapse of the rouble would also reinforce
the Russians' fear that foreigners are dominating their economy,
strengthening the nationalists who could replace Boris Yeltsin,
the president, and his reform-minded government with an
anti-western Russia-first regime.

So the Russians have a lot at stake in rebuilding reserves to a
level that is strong enough to prevent a successful attack on the
rouble. Mr Yeltsin and Anatoly Chubais, Russia's recently
appointed chief negotiator with the International Monetary Fund,
have said that they want to raise $10b to $15b. They want to
borrow this from the group of seven large industrial nations or
from the IMF on more favorable terms than the market would
provide.

At the recent G7 meeting, these countries passed the
responsibility on to the Fund. Although the IMF is currently
talking with the Russians about new credit, it is very unlikely
to lend the Russians anything like the amount they need. It has
been difficult enough for the Russians to prize the latest
$670m of previously agreed lending from the Fund because of
Russian failure to achieve the economic reforms that the Fund
wants. That failure has been made likely, if not inevitable, by
the make-up of the Russian parliament, the Duma. This is
dominated by opposition politicians who oppose the IMF policies
in principle and who would gain from the economic chaos that
would follow a rouble collapse. The IMF has said that any
additional credit would take months of tough negotiations and Mr
Chubais has said that Russia will not accept all and every IMF
condition just to get cheaper financing.

So what about the alternative of raising money in the markets?
The Russians recently raised $4hn in the eurobond market, pushing
the interest rate on Russian 10-year dollar bonds from 12 per
cent to 15 per cent. It would be good if Russia could raise an
additional $15b of long-term funds in this way, even if the
interest rate were pushed up towards 20 per cent. Although
borrowing $15b at 20 per cent and investing it in US Treasury
bills at 5 per cent would cost Russia $2.2b a year, that would
still be a low-cost insurance against economic disaster: $2.2b
would be less than 3 per cent of Russian exports and only 0.4 per
cent of Russia's gloss domestic product. Even paying more than 20
per cent to borrow long-term dollars could be a good investment
in Russia's future stability.

But amazingly, the IMF's chief representative in Russia has
publicly advised the Russians against rebuilding their reserves
by more long-term borrowing because of its high cost. The IMF is
right to stress the desirability of cutting the current account
deficit by correcting Russia's fiscal imbalance. But such cuts
cannot work quickly enough to prevent the sort of potentially
devastating consequences that currency collapses have visited
upon those Asian countries that lack large reserves. Removing
the risk of currency collapse would also permit lower interest
rates on Russia's rouble debt, significantly shrinking the
country's budget deficit.

It may be impossible for the Russians to borrow enough in the
markets even if they are willing to pay more than the current
rate on Russian dollar obligations. Foreign lenders are rightly
nervous about the country's ability to repay such large
liabilities. The Russians wisely sought to supplement their
borrowing by offering to sell Rosneft, the largest Russian oil
company, to foreign buyers at an attractive price. There is
enormous value in Russian assets and enterprises that have yet to
be privatized. Russia will attract additional dollars as foreign
companies buy roubles to make new investments in Russia. But all
that takes more time than Russia has if it wants to avoid a
devastating currency run.

What then can be done? A new kind of Russian bond, which I will
call a Privatization Bond, might allow the Russians to tap the
international bond market for larger amounts and at lower cost
than traditional privatization bonds. The new instrument would be
denominated in dollars but, unlike other bonds, would not have a
fixed maturity. The bonds would instead be acceptable by the
Russian government as payment for privatized assets and could be
used instead of dollars as a way of financing investments in
joint ventures or other forms of direct investment.

Investors who buy Privatizations Bonds could use them for these
purposes or could sell them to any prospective buyer of Russian
assets. They would know that the Russians had a strong incentive
to redeem the Privatizations Bonds quickly to raise new money by
further Privatizations.

By issuing $l5b of Privatizations Bonds, the Russians would
obtain $15b in foreign exchange reserves while having no new
dollar obligations (other than the need to make dollar interest
payments.) This would have doubled Russia's foreign exchange
reserves while leaving its short-term foreign exchange
obligations essentially unchanged.

By using the market to increase reserves instead of depending on
deals with the IMF or the G7 countries, Russia would maintain
control over its own economic policies and the government of
Sergei Kiriyenko, the prime minister, would deal with opposition
parties in the Duma from a position of strength.

With ample reserves, the Russians could use a small or gradual
devaluation of the rouble to regain competitiveness and increase
taxable profits something considered too risky to attempt in the
current situation. Lastly, when the Russians achieve current
account surpluses, they could retire some of these bonds through
open market purchases rather than through asset swaps.

It is time for the Russians to stop seeking special deals from
the IMF and the G7 countries and to use the market to save the
rouble. Borrowing against the future proceeds of privatizations
sales may hold the key to protecting the rouble today.

The author is professor of economics at Harvard University and
president of the National Bureau of Economic Research